11/10/2019
Financial Statement Analysis & Interpretation - Part 1
By
Oluseye John (ACFRC)
Users of financial statements need financial information to make their economic decisions. It is believed that information is not complete until it is understood by the users. That is why we have "Understandability" as one of the characteristics of financial statements information. However, how will a user make his or her economic decision about a company when he/she cannot interpret or decode the financial information of that company? This is the reason why the analysis and interpretation of financial statements is essential.
What is financial statements analysis & interpretation?
It is the process or an act of assessing the financial performance, financial position and cash flow status of an entity with the use of tools and techniques necessary to understanding the financial statements.
Users (existing and potential) require information about an entity in order to make decisions on what and where to spend their money. However, all these users have different expectations and interest. They all depend on the general purpose financial statement to make their investment/capital allocation decision. For example, a shareholder will be more interested in the profitability of a company while a bank will be more interested in the liquidity position of the company. They don't always have to make use of the same information or have same expectations. Their expectations and needs drives their information need
So, in analysing and interpreting a company's financial statements, attention should be paid to all available information e.g Statement of Profit or Loss which shows the financial performance, Statement of Financial Position which shows the financial status, Statement of Cash flows which shows the liquidity position of a company among others.
As an investor, never you make the mistake of depending on just one component of Financial Statement in making ur decision. All the statements mentioned above have their purpose which are intertwined.
In carrying out this analysis, one major tool which is apparently the most popular tool in the industry in interpreting the financial statements is the "Almighty Ratio".......we will address this later.
For the purpose of your examination, you are not only expected to know how to calculate the ratios but more attention is placed on the interpretation of your calculations. Please and please especially for the professional level students and those writing Case Study, your analytical skills must be sound. At this stage, we see you not just as an accountant, but as a financial analyst capable of examining & diagnosing a company's financial records.
ICAN cannot afford to produce chartered accountants that won't be able to say something about the financial statements presented before him/her. This is why 20℅ was specially allocated to this topic in your syllabus (F.R and C.R)
Just follow my discussion bumper to bumper when we begin the calculations and analysis. Analysing financial statements will be cheap for you. So, stay tuned.
Just like the medical doctor will analyse a test result and carry out necessary diagnosis and examination of the body, so also is the financial accountant expected to diagnose and analyse the financial statement. Our patient is the financial statements. We must understand the language it is speaking in order to give appropriate advice to our clients. Also, just like lawyers will analyse and critically examine a case, we also expected as professionals of numbers to be able to analyse the financial statements which contains both financial and non-financial information.
You can see why you can be called a financial analyst. Don't come and fall our hand when they present you financial statements to analyse, evaluate and interpret.
Types of Financial Statement Analysis:
Listen, the figures displayed in the financial statements makes no sense without analysis/comparison. The essence of analysing is to compare something with something to get the information you need. All those figures you are seeing on the financial statements can be deceptive and misleading if one is not careful. That is why we need to establish the relationship between those figures by comparing one to the other. This gives rise to the use of RATIOS.
Ratios is a tool used to establish relationship between figures or items of the financial statements. What we may not see with our eyes may be revealed by ratios. See, there are a lot of things behind the numbers. We need to use our physical and spiritual eyes to see some hidden things behind the numbers. With ratios, you can assess the performance of an entity in the current period in comparison with prior periods. You can only know whether a company is performing or not through comparison. Improvement or decline in performance will be ascertained through comparison. We shall be looking into the tools that can be used to carry out the analysis later.
Types of Analysis / Comparison
1. Intra-Company Analysis
2. Inter-Company Analysis
3. Industry Average Analysis
4. Proforma Analysis
5. Common-Size Analysis / Vertical Analysis/Horizontal Analysis
Intra-company analysis also known as trend analysis or horizontal analysis involves comparing a company's performance over time that is, over some years of the same company. E.g comparing your company's result over 5 years or less or more. Under trend analysis, you are comparing with prior years and not with a rival company.
Inter-company analysis on the other hand involves comparing an entity's result to another rival entity's result. It is also called cross-sectional analysis. E.g MTN comparing its performance against Airtel.
Industry Average Analysis as it implies requires comparing an entity's performance against other players result in the industry. This is usually through getting a benchmark or industry average parameters against which an entity can compare its performance. At times, an entity may think it is performing well on its own but when it is compared to the industry, you will realize it is just a market follower and vice versa. Also, an entity may be performing poorly individually but when compared to the industry, it might actually be doing better than others in the industry. So, take note when you have industry average information. They are there for a reason.
Proforma Analysis may involve comparing results with forecast or budget or anticipated results.
Common Size Analysis can be vertical or horizontal analysis. Under vertical analysis, you express a particular financial statement line item in a particular year against a chosen base item. E.g if you want to know the proportion of cost of sales to revenue or portion of inventory to total assets e.t.c
You can do this on a vertical basis and on an horizontal basis.
So, in essence, the tools that can be used to carry out analysis are:
*Ratio Analysis
*Common Size Analysis
Under the above, you can do trend analysis, vertical analysis and horizontal analysis. Having a good understanding of how these analysis are done will be a great weapon for you now and later in your career. Common sense and Experience are other useful tools that can be deployed to analyse, evaluate and interpret the financial statements.
Categories of Ratios
1. Profitability ratios
2. Efficiency ratios
3. Liquidity Ratios
4. Stability Ratios
5. Investors Ratios
Acronym - PELSI
For the purpose of your examination, please master at least three ratios under which. Even if it is just three per each category, it is okay. It means you will have a total of 15 ratios to compute and analyse which is okay for 20 marks.
You should note that your analytical skills is what we appreciate the most. Your computation alone will not take you far. Even skill level students are now being asked to write report on the ratios dey have computed.
This is where we know whether we can call you a financial analyst or beans analyst.
Ratios despite its usefulness has some limitations that makes us wanna reduce the level of our reliance on the use of ratio alone as a tool for analysis. We will look into this later.
Please note my next statement. That might be the next approach to test your knowledge of financial statements analysis.
Remember that users have different and various information need. You need to be able to identify each users and the type of information they will need for the decision they want to make.
Don't expect a question that will ask you to compute ROCE, current ratio, gearing e.t.c Your question will most likely come in form of determining and calculating relevant ratios for some user groups...... You might be lucky for them to tell you the ratios to compute but don't always expect it. So, try to identify each users and what type of information they need for their decision. For example, a bank that wants to give loan to the company will be more interested in the liquidity ratios and gearing plus profitability. Meanwhile an investor or potential investor in shares of the company will be more interested in EPS, DPS, P/E ratio, profitability ratios......
So, be careful.
Ladies and gentlemen, we continue from here tomorrow same time and venue.
Thanks for joining me. Good night.
Source: Accounting and Finance Resource Centre (ACFRC)
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LECTURE TIME TABLE FOR NOVEMBER 2019 DIET
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